CFA Level I- Portfolio Management- Part I

We try to understand certain concepts 1) What is the meaning of Portfolio? Let us say that you have some assets some amount of cash and you decided the entire amount of cash you are planing to invest into stock of let's say Relaince so you had 10 lac Rupees in cash and you decide you would invest entire 10lacs then we would say that your portfolio made of reliance stock and entirely of 10 lac rupees it was not like this and I would like to invest 9 lac rupees in this and 9 lac rupees in reliance remaining 1 lac rupees you would keep in cash you would say your portfolio is made of reliance + cash if you have some real estate you will add that here if you have a house, if you have a car all those assets combinedly would called as portfolio now the question is it Why the portfolio concept is so important? so why do we say so much on portfolio let's imagine that the you a portfolio which is made of A, B, C, D and E assets classes you have different assets classes different categories of securities into this particular portfolio now you come across an investment and this investment let's called it as "Z" now this investment is really really good and independently if you see this you will say the its really nice investment and I want to invest my money but when you see investment from a concept of portfolio you do not have to decide whether this investment is in "Z" in scope but what you need to decide is when I will add this investment to my portfolio How it was affect the performance of my portfolio and that's why the subject becomes really important because by this time your body to study meaning of equity so you know well the bodies equity you already know derivaties you already know fixed income or I am assuming that you know that and then finally you would get to know Alternative Investments you would know all these 4 categories of Investment that means by the time you will pass level I you will get expert in ACID value evaluation but then knowing only equity is not sufficient because you would need to know that the client says that I have a portfolio of $100 million how much out of this amount you would planing to invest into into equity how much should be derivatives how much of this income should be in fixed income and how much this amount should in Alternative Investment and this is way portfolio management will help you now 3rd point is called as concept of "Diversification" common practice generally the tendency is that once you started working in corporates and let's say that you are working with company L&T and let's your the very very Sr. Manager level :) now you have the excess cash of let's 1.5 Cr. you decide I want to invest a cash into equity market now you go to some GURU (adviser) and we says that you want to ideally you should invest in those stocks where you exclusively expert with business process you understand business necessary.. and you are really comfortable way things funcation so what did decide to do is? you say that I am going to invest the entire money into My own company that is I am going to invest entire money into the L&T it self so now this 1.5 Cr. cash you that have now that do you invest that money into L&T now see what happens is that let's assume that the company is going really good which means that your salary is increased substantially now because company also going good the value for portfolio is going to increased but now in case if the company is stops performing good and if there is a some thing wrong with the company there are two consequences one is you will loose your job simultaneously if your time re investment .....the role that is the time manuipueal..

investment also reduced substantially and this why the concept of portfolio is becomes really important because what would we say that your Job that means your salary and the value of investment are positively relative to each other ...... I will call concept as "Co-relation" and we will say that co-relation is positive number and there fore when the co-relation is very positive when one is increasing other one is also increasing it is not giving you required --benefits ........... IOP infra insdustry let me figure out if it get any kind of shock which got negative co-relation with industry so every time my there is something going with my job atleast value for investment will increase and it will give me some protection the same logic is applicable for investment so client come and says I want to invest 100 million the first question that is asking is What is the level of Risk averseness? and this averseness means that how much the client is willing to take risk? so you cant tell that the somebody risk covers it means Someone whose not at all meaning of Risk averseness avoiding risk that some how you want to eliminate risk not willing to take risk so every time we take some decision we will do it part of portfolio you try to judge what is the risk awareness of that particular plant do some decision getting for him now once you decide Risk averseness then you would say that the client is some rating let's the client is category B now everyone will have rule proprietary writings now this category B means client is moderate he does have some risk type but play simultaneously 40% equity 30% debt you said that to manage equality remaining 30% of cash now once you chosen that this 40% is invested into equity then you will have multiple choices whether I invest into small caps whether I should invest into mid caps or whether I go only for blue chips now within that which sector do I want to sector specific do I only want to IT industry or do I want to any other industry so these kind of questions are answered by the theory of Portfolio management how much in that how much in equity within equity what category within category what amount into what category all those question would be answered and one answer for all those question is called as "Optimisation" so that human level of risk you try to optimize the rate of return that is to be received by this particular investment now we will start with level one curriculum and the entire curriculum or the entire textbook that you would find out on portfolio management that would be based on work of one single person the name of this person is "Harry Markowits" if you must be knowing that the way economics is probably 5000 year old or it might be 7000 or 8000 , 3000 year old Finance is 150 year old its relatively new subject which means that all those big theories which are their or which have been developed various people those people are still living.. same in case of this person as if now he is still exist and he is about 80- 85 year old and he is still professor with Chicago University so what will this guy do he first studies philosophy then got boar and let me study some statistic then he decided let me use my philosophy knowledge and statistic and little bit of economics let me put that into theory of portfolio management and then he created that theory and the theory was so popular in 1997 and this guy got the noble award in economics for his work now its a very controversy theory because he would try to explain his concept using graph, curves, linear relationship, regression equation I will do that slowly slowly .. and the entire theory is based on certain premises and certain assumptions and one of its assumption people find is very funny is the assumption of "Rationality" he says that the investors are rational and the entire calculations entire assumption entire theories is based on these one basic fundamental principle or assumption and some how the people realize that this assumption is never through in the market and it might their is one particular person who loss good amount of portfolio who loss good amount value of portfolio he was trying to manage his portfolio based on the principle given by this particular person so off course the case was not validated but their was a big lough happen in US news papers because it was very rare that someone who's the magic of portfolio someone who developed theory on particular subject let's try to understand what is particular person try to say to us now through out this we are going to do lot of mathematics because portfolio management is about optimization mathematics we will try to do it step by step now what he go to says that there are so many assets and there are different categories of return and 1% of receive from these assets he says that what are those criteria based on which selection should be done should I select assets based on what is glossary sales should I select the assets based on how much return this particular stock has given in the pas he says that there are only three parameters which are important to select the particular stock 1) What is the expected rate of return? from this particular stock or this particular assets which they are talking about so now this expected rate of return might be futuristic for example Itech and L&T I said that in last 5 years L&T has given rate of return let's say 7% per annum that's historical probably I might think this year L&T going to be 11% or 10% whatever it is we want expected rate of return Benefits that the first criteria that we receive second one that's fare enough your given return of 7% but how consistently this assets has been either 7% so that consistency is to be measured by the that something is consistent that means it not volatile that means it was not deviating so we try to measure volatility by funny derivations so I will avoid using standard derivation I would simply say Volatility of returns or simply "Volatility" and third where it places lot of importance this is fare enough you see Volatility you would also see expected rate of returns but the most important things that is you see those investments from the concept of portfolio that I already said assets with me I am going to add one more assets towards so that the moment add one more assets to my portfolio how what kind of changes it is going bring to the existing portfolio and generally we would try see by calculating certain numbers likes co- relation at this I simply say Relationship between various assets in the portfolio Relationship between various assets in the portfolio so what do I mean to that let's say that I want to diversify lets say 100 lac with me I decided out of this 70 lac I am going to invest into some real estate some flat, some land etc and simultaneously if I invest my remaining 30 lac Company like DLF then probably both the assets have positive co-relation that is the real estate would increase , DLF will also increase reale state decrease then DLF also decrease so then probably I am not giving message to benefit of diversification so only considering real estate is not important I also like to consider that when I adding to my existing portfolio what impact it is going to entire portfolio of my company or entire portfolio of my investment once this is done now you write down this concept first concept is called as "Standard Deviation" the first way logic behind this and then we will going to mathematical computation I take two stocks this is my stock A this is my stock B I am trying find out what is the rate of return these stock are lets my last 6 month so we will find out monthly rate of return writing 1,2,3,4,5,6 first month let's give you 10% second stock immediately gives you 40% then its gives you -30% then gives you 20 then gives 50 and then gives you -30 the other stock it is gives you 10% all the time it is not deviated all the time let's assume that fixed income instrument so forget it lets called it as Some Bank so 10% ..... now what we do is first thing that I do is I will first figure out all an average which investment has giving you more returns that means I would simply calculate the mathematical average for both the stock so (total of all)/6 the mathematical average A investment is equal to 10% and mathematical average B investment is obviously again 10% just check it again I hope you don't need calculator for this :) now I know that the average rate of return which has been given the both the investment exactly same but then given an opportunity out of these two which one would you prefer to investant there is so much volatility and now we are going to call in the concept of portfolio we are going to say volatility is risk so there is so much risk in A where as rate of return in B is exactly 10% there is a absolutely know volatility which means it make sense for me to invested to the assets B by in case you decide that we want to calculate standard deviation for this the formula for the standard Deviation is going to be Is there any one who scares mathematics ? :) as given in video n is only for population and n-1 is for sample sample is a small part of your entire population the first one is S.D for population meaning of population is that if I want to calculate on an average CFA candidates studies a Level I candidate all over the world then all those people those are registered for level I are going to the population If I try to derive same conclusion by trying to figure out how many on an average you took the study then you are the small sub set of entire population the you called as sample So if I calculate the S.D. for a sample by given formula class room discussion that there might me 1000 observation now there is a very very good possibility that out of 6 variable that I chosen one of those variable was it mean my self there was good possibility that out of whatever random variable that I chosen one of those is my mean so would happens is that is my formula see in video I thing my small sample and based on my sample I will try to predict the S.D of the entire Deviation and I want to more conservative in my approach and I want to divide this by small number so that the S.D. Becomes bigger number the scientific reason is for sample is n-1 how much room you have move around how much comfort move around in population is n coming to sample you will shrink your degrees of freedom degrees of freedom is n-1 the interpretation of this is very important so what will we do is calculation is understanding and try to understand the Standard of Deviation for this just spend some time on analysis of this so let's start the calculation of this particular variable see formula time to solve example ans is 31.01 & 34.05-- now calculate these two Standard Deviation? The you must know or I am assuming that the S.D.'s Square is called as variance this we done in 6th std.

:) now let's stock A and Stock B A is 10, 20, -40, 10, 40, 30 B is 10, 19, 27, -57, -42,90 Calculate the Standard Deviation? as given problem that is A and B answers given in video please solve it now next one this number is called Covariance formula as given in Video now what does this Covariance means? minimum this number is that if you have two data set A & B When Stock A give 10% where stock B is 12% resply. 6%, 8% , -10%, -14%, -30%, -35% which means one is increasing other one is increasing one decreasing other one is decreasing so we try to see that what is the strength of the relationship one is increasing other one is increasing one decreasing other one is decreasing and we try to measure the strength based on this particular variable Covariance Stock A and Stock B this one set the other one we considering is C and D just a minute so now we are creating some random prizes for this between 100 and 200 for B between 300 and 400 now we have these two sets of prizes whatever the relationship exist betn A and B probably same relationship between C&D the relationship is exactly is same only the numbers are different. now I would calculate the covariance of this two data sets and also calculate S.D. for A and for B now I am going to use direct formula so we can save time here Covariance is come out is negative and the meaning of the negative is that when one is increase the other one is decreasing so that's why we have negative covariance but now isn't covarience is measured of relationship between these two the ultimate purpose of the Covariance is we want to see that how strongly A and B is linked or how strongly C& D is linked so ideally those absolute value of B is different their Covarience come to the same because the relationship is same we say that covariance is not same Why if we will go back to the formula as x-x(bar) and y-y(bar) absolute value of your variable is very very high automatically the Covariance come out to high so then can I conclude from this that says this Covarieance let forget there is a negative number so can I conclude that this larger number there fore the strength of relationship is same C&D than A&B that means the number of covariance large or small which not telling us which one is stronger than which one covariance is only tell us that the number is Positive relationship is positive but we can not say that the covariance of 10 and Covarience of 20 if you have these two sets Covariance of 20 is stronger relationship than Covariance of 10 we cant conclude that the only thing that can be conclude is a positive covariance means positive relationship when one increases other one is increases negative covariance means negative realtionship when one increases other one is decreases now I am going to do is ..I am calculating S.D for stock A and stock B again I would use direct formula calculation S.D of A and B same two number calculation for C & D as well again can you see that S.D is A is 24.250663 where as S.D of other is 2425.07 again S.D is higher absolute number I use this relationship for my benefit but when absolute data set is very very high covariance is very high number S.D.

is very very high number so want to standardized these two If I want to compare A & B vs Relationship with C & D then I would standardized this and I will calculate a number I will call that as "Corelation" and how will I calculate that number I will simply say a higher covariance divided by both the S.D. together and now the correlation will come out is exactly same and since corelation is standardized it is what affected by the absolute values of individual variable we can conclude that corelation of probably 0.5 between corelation of 0.5 and 0.7 0.7 is stronger relationship than 0.5 is it clear ? already calculate co-relation I use this formula I said Co-relation = (covariance )/(S.D. of First stock * S.D of second stock) Co-relation = (covariance )/(S.D.

of First stock * S.D of second stock) it gives you co-realtion coefficient it take lot of time to realy clear these things.. after few example it will be more clear..